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Mutual Fund Basic Training: Indexing Vs. Active Management

I'm about to wade into an old and heated debate within the investment community: Does it make sense to try to pick the best mutual funds? Do mutual fund managers really add any value by successfully picking the best stocks and bonds? Are they worth their fees?

Alas, the answer is frequently “no.” In fact, for all their advanced degrees and sophisticated training in security analysis and risk management, data has consistently shown that taken as a whole, professional mutual fund managers have generally not been successful in beating the market, once you take their fees and costs into account. It is clear from years of data, that identifying the best stocks and bonds in the market, and for that matter, identifying the best mutual fund managers most likely to “beat the market.”

Instead, most investors are better off buying a special kind of fund called an “index” fund.

What’s an Index Fund?

An index fund is a mutual fund that simply owns the stocks or bonds in a given index. So what’s an index, you ask? An index, in this context, is simply a theoretical construct: It’s an unmanaged collection of securities designed to be representative of the performance of a given market. For example, the S&P 500 index generally approximates the wealth created (or lost!) by the 500 largest publicly traded companies in the United States. The Wilshire 5000 tracks all publicly traded stocks on the New York Stock Exchange – which means that index also includes some small-cap stocks as well. And the Russell 2000 tracks the performance of U.S. small-cap stocks. The familiar Dow Jones Industrial Average – despite its fame, is actually a very narrow index of 30 giant publicly traded companies.

An index fund simply owns the securities included in an index – weighted, generally, by their market capitalization. That means the bigger the company, the more weight it has in the portfolio. In the case of the S&P 500, the top 10 holdings represent more than 20 percent of the fund.

The excellent Thrift Savings Program consists primarily of index funds. The C fund, for example, is simply a fund that tracks the S&P 500 Index of large cap stocks.

The Index Advantage

Professional mutual fund managers make a great deal of money, as do mutual fund analysts, in most cases. The kind of financial expertise it takes to do detailed research on companies and industries is in high demand, and these people routinely make six-figure and multiple six-figure salaries. Some celebrity fund managers, like PIMCO’s Bill Gross, can make millions in fees.

And professional traders, of course, like to trade a lot. Every time they do, they rack up more and more expenses in brokerage commissions and bid-ask spreads. These expenses ultimately come out of your returns.

An index fund, on the other hand, needs no professional money manager. Nor does it need a big staff of analysts to pick and choose securities and rack up expenses. Instead, the index fund company can program a computer to simply take new money that shareholders contribute and buy stocks in the index. And so expense ratios for index funds are a fraction of the cost of actively-managed mutual funds.

The difference is dramatic: A typical actively-managed large cap US mutual fund can easily charge you 80 basis points (0.8 percent) of your assets each year in expenses. A typical index fund will charge less than a quarter of that, or under 0.2 percent.

If you buy your stocks via the Thrift Savings Program, however, your expense ratio in the C Fund is even lower: Just six basis points, or 0.06 percent of assets. Over time, that savings can be quite substantial.

Furthermore, index funds don’t have to trade much. Once a stock or bond is in the index, it tends to stay in the index for a very long time. The only trading an index fund should have to do is put new contributions to work, or sell enough to meet any net redemptions when investors want to withdraw more money on a given day than they contribute, or to sell off any securities that fall off the index for whatever reason.

In contrast to the “active management” approach, we call the indexing approach to investing “passive management.”

Tax Efficiency

The lower trading levels mean that index funds tend to be much friendlier to tax-sensitive investors than actively-managed funds. Here’s why: Normally, when a mutual fund sells shares of companies at a profit, those profits are taxable as capital gains. The mutual fund company then distributes those capital gains among its shareholders. Each shareholder must declare any gains, and therefore pay any capital gains taxes, on his or her individual income tax return.

Index funds, however, don’t have to do much trading. They therefore don’t generate much in the way of a tax bill for their shareholders (except for tax on dividends). What does that mean? It means that the investor, rather than the IRS, gets to keep more of his returns, over time.

Bear in mind that tax efficiency doesn’t count for much for funds in retirement programs. There’s no capital gains tax on funds in 401(k)s, IRAs, SEP IRAs, SIMPLE IRAs and the TSP. However, index funds make great sense for holdings outside of your tax-advantaged retirement accounts, precisely because of the tax efficiency issue.

By Jason Van Steenwyk

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